Since liquidity risk can be damaging it has to be understood, measured, monitored and managed.
Unfortunately, there is no simple way to measure liquidity risk – in our view the best that can usually be done is to refer to certain proxies that will indicate the presence, and direction, of liquidity risks.
First, from an overall perspective a firm needs to take account of its legal structure – this allows it to understand whether liquidity will be available when needed or whether it will get trapped. Assets in one part of the organization may not be readily or cheaply accessible by another part in times of need; likewise, a financing facility granted to one subsidiary may not be available for drawdown by another subsidiary. A company might be able to raise funds in one subsidiary but not channel them to a subsidiary where they are actually needed. Though the entire company may be liquid and solvent on a consolidated basis, such restrictions could actually cause it to default! Capital that exists to support the operations of one legal entity often cannot be repatriated or moved to another part, and should not be considered part of an emergency liquidity plan (even if allowed, there might be high tax costs associated with the transfer). Enterprise-wide knowledge of legal entity structure, and associated assets, liability, capital, financing facilities, commitments (along with a “forward view” of operations) and tax/regulatory restrictions is crucial to proper liquidity management.
A firm must also be aware ofdouble leveragethresholds that could impair its credit standing or breach regulatory rules. For example, if a company borrows directly through its holding company and must tap the debt markets through its operating company for additional funding (e.g. in the event of an unexpected need), it has to make sure its consolidated borrowing (e.g.
leverage at the operating and holding company levels) does not run foul of credit rating triggers or regulatory restrictions; excess double leverage can raise borrowing costs, hamper access to liquidity or lead to a rating downgrade. Any of these can exacerbate the liquidity crunch, and lead to a broader liquidity spiral.
Second, from an asset liquidity perspective a firm must monitor its:
r
Asset maturity profile,r
Portfolio credit quality mix,r
Aged assets,r
Concentrated risk positions.By trackingasset maturitya firm knows when assets will be converted into cash or be written down to zero – allowing reinvestment, repayment of maturing debt or a lowering of equity. A financial trading firm or investment company features a fairly high percentage of short-term assets, while an industrial company has more long-term fixed assets. If the financial firm’s asset maturity profile starts to lengthen, it may be more susceptible to increased liquidity risk (the same would be true for the industrial company, though its proportion of assets in the liquid sector is much smaller to begin with). The mix ofcredit qualityin the portfolio also needs to be monitored closely; it should always contain a relatively large proportion of high-quality assets that can be converted into cash with no (or minimal) discount in value. This is especially important in a deteriorating credit cycle, when the credit quality of the assets in the portfolio starts to decline, to the point where they are far less liquid and cannot be realized without taking a loss. Monitoring the size and movement ofaged assets– those that have been on the books for several months but are assumed to be available for sale – can also be a good liquidity indicator.
This proxy is applicable primarily to trading companies, which should feature regular turnover of assets as a normal part of the business. If asset turnover slows and more of the balance sheet shifts into an “aged” category (e.g. 90, 120 or 180+days), asset liquidity risk is likely to be on the rise. A large amount of aged assets also often indicates a problem with valuation of these positions. Traders are very quick to point out when a position is undervalued, but rarely do the reverse. A position that is overvalued is unlikely to be attractive to others in the market place and will sit on the books. Monitoringconcentrated positionscan also help identify problems.
As noted earlier, large positions are generally less liquid than smaller ones; in the extreme, a large position held on a firm’s books may take days, or even weeks or months, to sell at, or near, the carrying value. Watching the size and number of concentrated positions can serve as another “early warning” indicator. Balance sheet, off-balance sheet and credit exposures should be monitored in such a fashion – asset liquidity is just as relevant in derivatives or credit risk as it is in cash instruments.
Funding liquidity risk can be monitored by looking at:
r
Liability maturity profile,r
Funding source concentration,r
Commitment percentages,r
Contingent triggers.Knowing thematurity of liabilitiesis essential in understanding what needs to be refinanced, when and at what relative rates, and whether refunding will coincide with cash from assets coming due.2 For instance, if a firm has 75% of its liabilities maturing over a three-month window, it may not have confidence in its ability to refinance everything. Accordingly, it has to compare the liability profile with maturing assets, match off any maturing assets with expiring liabilities and identify other assets that will have to be sold to meet the liability refunding.
Monitoring funding source concentrationis vital, and creating a diversified program of fund- ing that crosses lenders, markets, products and maturities is advisable. Concentrations can lead to an increased incidence of funding-related losses, as the disappearance of a significant banking source might force the firm to seek more expensive alternatives (or turn to asset sales).
It is also important to monitor the percentage of lenders willing to extend funding on a truly
2Financial institutions commonly compute a “funding gap” by comparing interest rate-sensitive assets and liabilities that are maturing or “repricing” over particular intervals, e.g. every six or 12 months. This helps them capture any gaps that might exist and indicates how they will be impacted if rates rise or fall during a given repricing period.
committedbasis (e.g. “escape-proof”); if the percentage starts to decline, the firm’s funding liquidity risk may be on the rise as it could lose access to lines precisely when it needs to tap them. This becomes especially evident when downgrades are afoot. For instance, over the past few years a number of large CP issuers – including Xerox, Kmart, Daimler Chrysler, PG&E and Lehman Brothers, among others – have been temporarily or permanently shut out of the CP market as a result of credit downgrades. This forces such companies to quickly find alternatives – precisely when market perception of them is negative. Facilities withcontingent triggersshould also be kept to a minimum (or triggers should have such a remote chance of being set off that they cannot realistically be a factor). Certain bank facilities contain language that allows cancellation (or forced repayment) if a firm is downgraded below certain levels, its stock falls below a prespecified price, or financial ratios are breached (e.g. leverage, liquidity, earnings). Knowing when these triggers might come into play, and how they can affect funding access, is an important part of liquidity management.
A firm cannot overlook the forward structure of on- and off-balance sheet obligations at var- ious time horizons; this provides an indication of gaps that may exist, additional commitments that might need funding, or assets that might have to be sold. Use of derivatives, securitization, special purpose vehicles and other off-balance sheet mechanisms has exploded in recent years.
Failure by the accounting profession to keep pace with these changes means that there is often a disconnect between a firm’s stated balance sheet and what is really going on – as revealed in the corporate accounting scandals unearthed in 2001 and 2002. Heavy reliance on off-balance sheet activities can reduce current funding needs but might create enormous liabilities in the future. These may be too large for the company to manage and honor. Only very detailed analysis of financial footnotes may reveal the extent of this risk, if at all. It is clear that the standard balance sheet and earnings reports do not provide much insight to future “IOUs”, and estimating the forward balance sheet is not easy – sometimes it has to be based on assumptions about future events that are very uncertain (e.g. it is impossible to know six or 12 months ahead of time whether a particular client will exercise an option or draw down on a revolving credit facility), so some “guesstimate” has to be made. Though imprecise, in our view some future estimate of what the balance sheet might look like is a useful and necessary step in helping manage liquidity and credit risk.
The measurement of asset and funding liquidity should not be confined solely to these proxies, but can be supplemented by others. We have found the tools presented here to be the easiest to measure and promulgate throughout an organization. Figure 3.3 summarizes important liquidity monitoring tools.
Asset maturity
Portfolio mix
Aged assets
Asset concentration
Liability maturity
Committed funding Funding
concentration
Contingent triggers
Figure 3.3 Liquidity monitoring tools